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Big Boom, Weak Profits

August 11, 2002

Trustworthy numbers are hard to come by these days. Corporations such as AOL Time Warner (AOL), Qwest Communications (Q), and WorldCom are under investigation for accounting problems. The reputation of the accounting profession is in shambles. And investigators in Congress and the New York State Attorney General's office have turned up e-mails confirming the long-held suspicion that analysts are pressured to write favorable reports about the companies they follow.

The one beacon of honesty left seems to be the government statistical agencies--and that's what makes the latest report from the Bureau of Economic Analysis so important. The gross domestic product report, released on July 31, showed that last year's downturn was deeper and longer than first believed. The economy shrank for the first three quarters of the year, rather than the single quarter that the numbers originally showed. That removes any doubt that the U.S. experienced a true recession in 2001. Moreover, the recovery so far in 2002 has been weaker than expected. First-quarter GDP growth, first thought to be 6.1%, has been revised down to 5.0%, while the second quarter clocked in at only 1.1%, less than half the 2.3% economists had expected.

But more importantly, the report revises the economic data for 1999, 2000, and 2001, giving a far clearer sense of what really happened during the New Economy boom and bust. The good news is that despite the downward revisions, the productivity gains of the New Economy were real. Since 1995, productivity rose at a 2.5% annual pace, according to BusinessWeek's analysis of the BEA revisions. These numbers might change a bit when the Bureau of Labor Statistics releases its official productivity stats on Aug. 9. While slightly lower than the previous 2.6% rate, that's still a big jump over the 1.5% rate that prevailed from 1980 to 1995.

The bad news: Corporate profits were much weaker than first believed. They've been revised down a total of $143 billion, or 6%, for the three years from 1999 to 2001. While the revisions were concentrated in telecom, utilities, and business services, the problem went well beyond a few bad apples such as Enron Corp. and WorldCom Inc. Profits, rather than peaking in 2000 as everyone thought, actually hit their high point in the third quarter of 1997, and have been bumping lower since, especially outside the financial sector. Instead of going towards profits, the benefits of faster productivity growth flowed out the door to workers and managers as higher wages and lucrative stock options.

That means the stock market was even more irrationally exuberant in 1999 and 2000 than anyone realized, skyrocketing in value even as profits tailed off. This has big implications for the future. The new data from the BEA suggests companies are going to have to go through a prolonged period of rebuilding earnings to make up for the deep profit decline. In a world where demand is weak and it's tough to raise prices, that can only mean one thing: continued intense pressure on companies to hold down labor costs by laying off workers, reducing wage increases, and restricting the use of stock options. Indeed, companies such as Avaya, Providian Financial, and Alcoa have announced job cuts in recent weeks.

In 2000, the notion that Corporate America was in the midst of a profits recession would have seemed like heresy. Companies were reporting respectable increases in earnings per share, with the BusinessWeek profits scoreboard showing a 17% gain in the second quarter of 2000 over a year earlier. Federal Reserve Chairman Alan Greenspan lauded the profit performance of U.S. corporations. Even the government's initial estimate pegged corporate profits at a record $964 billion in the second quarter of 2000, a rise of 15% over a year earlier. That made the sharp rise in stocks at the time seem at least plausible, if not fully rational.

But over time, the government statisticians refined their profit estimates, mainly using information from tax returns submitted to the Internal Revenue Service. The IRS data has several advantages. First, manipulating tax return data is harder than distorting earnings statements, since there is no such thing as a pro forma tax return. Second, the tax data for profits, unlike the financial reports for investors, treat the cost of exercised stock options as an expense. Finally, tax return data includes all companies, from money-losing startups to the biggest multinationals.

With each successive revision, corporate profits have dropped. The declines for nonfinancial corporations were especially dramatic. In March, 2001, the BEA originally reported profits for 2000 of $631 billion. Then in June, it revised the number down to $550 billion. The latest release shows only $462 billion, a number well below the overall profits figure for the preceding several years. Profits for 2000 now appear to have fallen 11% below the revised 1999 total of $518 billion, and 17% below overall 1997 profits of $556 billion--the year they peaked.

It may well be that the bad news is not over, either for 2000 or 2001. As companies such as WorldCom officially restate their profits, they will refile back tax returns, which will eventually show up in the government figures. And the BEA's profit numbers for 2001 are vulnerable to further revisions as more complete tax data become available.

The profits revisions show just how weak many companies became in recent years. But how did so many fall into such bad shape? A lot of startups ran up big losses during the tech frenzy of 1999 and 2000. Not surprisingly, the industries with the biggest downward revisions in profits were business services--most of the dot-com startups--and new telecoms. Webvan had $438 million in operating losses in 2000, PSINet lost $735 million, and Global Crossing lost a whopping $1.4 billion. Remember Pets.com? It lost nearly $100 million in 2000 before closing down.

Moreover, the BEA also subtracts the value of exercised stock options, which can be enormous. For example, Kenneth Lay and Jeffrey Skilling of Enron exercised stock options worth $185 million in 2000--an expense that shows up as part of the government's overall profit data but not in reported earnings. In telecom, top executives took home at least $500 million from exercised stock options and other long-term compensation in 2000 alone, and perhaps much more.

Finally, companies were simply paying a lot of money to managers and workers. Of course, part of this was the outsize compensation packages executives got. But the biggest cost was the rising outlay for ordinary workers. During the boom years, companies were hiring people at a frantic pace and paying them more and more. Surprisingly, the wage increases continued even into the recession. From 1997-2000, real wages rose by 5%. And since the end of 2000, real wages have risen by another 3%. All told, from the first quarter of 1997 to the first quarter of 2002, compensation to workers and executives, including exercised stock options, rose by $1.4 trillion. By comparison, corporate profits were flat.

The recession in New Economy profits helps explain why there was so much accounting chicanery during the boom years. Companies were under pressure to show earnings growth, even while their real profits were declining. The hidden weakness also explains the devastation in the stock market over the last couple of years. In effect, stock prices had been soaring for three years, from 1997-2000, while earnings had actually been falling. As a result, it took a wrenching bear market to get stock values back into line with profits again.

But the readjustment won't likely stop there. Profits at nonfinancial corporations are still only 8% of corporate output, way below the 11% in 1998. To get profit margins back up to a normal level, companies will have to hold labor compensation flat for at least another year. That likely means cutbacks in health benefits, smaller wage increases, and fewer jobs.

Still, there is no sign in the revision that the central achievement of the New Economy--faster productivity growth--is disappearing. Indeed, the latest numbers strengthen the case that output per worker is still rising at a full percentage point faster than it did in the previous 15 years.

But the new numbers also show that productivity growth is not a magic elixir. Just as the U.S. economy experienced high productivity growth with flat or falling profits, the pendulum may swing back the other way, and we may be entering a period of high productivity growth combined with a weak labor market. By Michael J. Mandel in New York